Stupid Money: What’s an IRA, Anyway?

If you’re planning on retiring someday, you need to know this stuff.

Stupid Money: What’s an IRA, Anyway?

“Personal finance.”

You know you should be doing it, but if your eyes glaze over when you hear those words, you’re not alone. The sheer number of investment options, the risk involved, the alphabet soup of terminology and the smarmy veneer of stereotypical “wealth managers” — the people who want you to trust them with your money, but whom you would not, in fact, trust with an empty candy wrapper — aren’t exactly alluring.

But here’s the thing: If you’re planning on retiring someday, rather than dropping dead at work, you need to know this stuff. With that in mind, we asked several smart people some very basic (some might say, stupid) questions about IRAs — starting with, what are they? (Turns out it stands for individual retirement account — so far, so good!) Here’s most everything else you should know about them.

Soooo… what is an IRA, really?
An IRA is simply a type of account, recognized by the government, where you can park money for your retirement, and which allows you to save money on taxes. You can either just leave it in there to accrue interest, or (since interest rates are a joke these days) invest it in all sorts of ways (stocks, mutual funds, gold, whatever) while it’s in there. You just can’t take any money out until you reach the age of 59 years and 6 months — if you do, there’s a 10 percent penalty on what you take out.

Retirement, eh? [mutters under breath] Dang.
Yeah, pal. It’s time to start thinking about retirement right now, no matter what your age. I’ll let Tom Warschauer, finance professor emeritus at San Diego State University, explain why:

“If you picture a bleak future of what it would be like to try to retire on Social Security, that should be enough to motivate you to save for your retirement. The IRA is an essential part of that — particularly for people who don’t have access to traditional retirement plans, like a pension or even a 401(k). For people making $50,000 to $100,000 per year, which I think is most people, if they’re working for a company without a retirement plan, the IRA is an absolute necessity for a reasonable lifestyle after you reach retirement age.”

Right, but I’ve already got a savings account — why complicate things further?
Well, the thing about savings accounts is that interest rates are so low, your money won’t grow. Then factor in inflation and you realize your money actually loses value over time — what you’re squirreling away now could be worth substantially less by the time you’re ready to quit working. A savings account is a safe place to put your money for the moment, but it’s not a good long-term solution. Plus, it has none of the tax benefits of an IRA.

Okay, what’s the deal with taxes, then?
Basically, whatever amount of money you put into an IRA, you can deduct from your taxable income. There’s an annual limit of $5,500, although when you reach age 50, that rises to $6,500. Now, the problem comes when you retire and have to take money out of your IRA — that’s the point you get taxed on it. The situation is exactly reversed, however, for a Roth IRA.

There’s more than one kind of IRA?
Yep! As we said, there’s also the Roth IRA, which, as we also mentioned a mere two lines ago, is exactly the opposite of a traditional IRA. There are no tax benefits as you put your money into a Roth IRA, but when you take money out in retirement, all that money is tax-free. You pretty much have to decide: Do I want to pay taxes now, or do I want to pay taxes later?

So… which should I do?
Good question! There are advantages to each — and plenty of differences of opinion. According to Warschauer, if you’ll be in the same tax bracket when you retire as when you were working, it’ll make no difference whatsoever. But, “If your tax bracket is going to be lower when you retire, then you’re better off with a traditional IRA. If for any reason your tax bracket will be higher when you retire (if you have a lot of investments, for example), you’re better off with a Roth,” he says.

Ed Slott, a New York City tax adviser who specializes in IRAs, makes a passionate case for the Roth, however:

“For younger people, they should all go Roths, that’s not even negotiable,” he says. “The greatest money-making asset any individual can possess is time. And young people have more of it than anyone else, and they could capitalize on it to grow that retirement. Older people like me don’t have opportunity to grow it.

“[Getting a Roth] locks in a tax-free retirement. What if tax rates go up? For this new tax plan, they cut rates by throwing everything on a credit card, building up huge deficits. The bill is going to come due, and when it does, it’s gonna fall on people who have tax-deferred accounts like IRAs, where the tax hasn’t been paid yet.”

In other words, people with Roths won’t be on the hook in retirement if the tax code changes, and everyone’s taxes go up.

“Remember: Your retirement account is only as good as how much of it you can keep,” Slott says. “It’s not how much you have, it’s how much you have after taxes.”

Where do I get me one of these IRAs, then?
Pretty much every financial institution offers IRAs. Most any stockbroker, any firm with a mutual fund and probably your own bank, which has a little desk in the lobby where the investment person sits. There are nearly infinite ways you can invest the money in your IRA, if you want to.

So I don’t just have to put my money in this thing, I also have to invest it?
That’s the smart move, yeah — again, since interest rates are so small, it won’t grow just sitting in there. You’ve got to accept a bit of risk — mutual funds, stock market index fund, things like that. Although the economy has its ups and downs, over the long term, you’ll still see your money grow. Usually your financial adviser will start moving your money into less risky investments as you near retirement, just in case the economy takes a nose dive right before you retire.

You said I have to take the money out sometime. Is that when I retire, or what?
At 70 years and 6 months, you’ve got to start pulling it out, whether or not you’re actually retired (these are called RMDs — required minimum distributions). You don’t have to take out all of it — it’s a proportionate amount based on your life expectancy. Very roughly, if you’re expected to live 10 years, you have to take a 10th of it out, for example. If you want to take it out a bit earlier, you can start at age 59 and a half, free of penalty.

Why is all of this so insanely complicated?
All the experts we spoke to wondered exactly the same thing!

Guh. Okay, what do I do with it after I take it out?
Whatever you want. You don’t have to spend it: You can put it pretty much anywhere — into savings, reinvesting it, hiding it under your mattress, it’s your call. The point is, the government wants to tax you on it sometime — you can’t just shelter it forever.

I have a 401(k) at work. How does that fit in?
You can roll all of that money into your IRA when you retire.

What else do I need to know?
There is the fact that not everybody can get one: People with very high incomes, or whose spouses have certain retirement plans, may not qualify. It’s complicated, so ask a financial adviser for the ins and outs of whether you qualify.

Anything else?
Just remember: Don’t treat it like a savings account — you’ll be penalized for taking money out before you hit the required age. Even if you run into some kind of emergency, Warschauer recommends borrowing money over taking it out of your retirement savings. And finally, put this information to good use: We’re talking about your standard of living when you can no longer work, and as boring as the details are, this is important stuff.